Stock-Based Compensation

Paying employees in equity rather than cash. The interesting question is not whether it is an expense — it is — but who bears it, and under what conditions the standard justification for it stops working.

The consensus, and where it broke

The four-part position most SaaS investors settled into, from Thoughts on Stock Comp in SaaS:

1. SBC is a real expense.
2. The equity-participation and retention effect of vesting is genuinely good.
3. Given prevailing valuations, it is not a major drag on returns and is best accounted for as dilution.
4. There is a “triangular social contract” between company, shareholders and employees: this compensation is more variable than cash and correlates with good times.

Points 1 and 2 survive. Points 3 and 4 are conditional on the multiple, and the multiple moved.

The arithmetic that decides it

Take a $100m-ARR company growing 30%, with SBC at ~20% of revenue — about $20m a year.

• At 15x ARR (a $1.5bn valuation), that is ~1.3% of market cap per year. Real, but not decisive.
• At 3x ARR, the identical policy means issuing shares worth roughly 7% of the company every year — turning what would have been a ~14% IRR into ~7% post-dilution, against corporate bond yields in the high single digits.

Nothing about the compensation policy changed. Only the denominator did. That is the whole lesson: SBC is a fixed percentage of revenue commitment being paid out of a variable asset, so its dilutive cost moves inversely with the multiple, and it costs most exactly when the company can least afford it.

The part that is a choice

As valuations fell, many companies “refreshed” grants to hold employees’ dollar compensation constant rather than issue the same share count at lower prices. That quietly converts SBC from variable upside participation into a cash substitute — and moves the risk onto existing shareholders.

The distinctive observation: unlike a distressed company forced to issue equity to survive, most SaaS companies have strong balance sheets. They are issuing dilutive equity at their own discretion, using shares management typically argues are undervalued.

Two proposed fixes

• Cap dilution with buybacks — commit to repurchasing shares issued to employees so dilution stays under a stated percentage. This converts excess SBC into a quantifiable cash expense with no change to the employee experience, and forces the board to manage it like one.
• Change the mix — more cash, plus out-of-the-money options on the normal vesting schedule. This restores the original intent (participate in the upside, rewarded for longevity) instead of treating equity as deferred salary.

Connections

• The same arithmetic as Riches in Niches and the concentration argument, run at the company level rather than the fund level: ownership retention, not headline value, is what determines the return. A shareholder diluted 7% a year and an LP whose fund holds 2.46% instead of 10% are losing to the same mechanism.
• It is the load-bearing input to the “garden variety SaaS companies are structurally unprofitable” critique — the source argues the critique is wrong but that unserious SBC treatment is what makes it persuasive.
• See SaaS and Capital Allocation; the dilution-vs-market-cap confusion is the retail version of the same error.